What is Optionality?
Optionality is the right of a party to choose from different allowable courses of action. In the case of the instruments on a bank or credit union’s balance sheet, the most common options are the rights to repay or demand repayment of principal balances ahead of schedule. There is also a class of options that allow a party to change other terms of the financial agreement, such as the interest rate.
Many investments, loans, deposits and even borrowings on a bank or credit union balance sheet have embedded options. We’ll focus our discussion on the most common sources of optionality, the investment and loan portfolios. In most of these cases, the counterparty (and not the bank or credit union) is the holder of these options and can be expected to act in their own self-interest and contrary to the interest of the bank or credit union. More about this later.
Some options are explicitly defined in the terms of the agreement between the counterparties, such as the call options on many U.S. Agency, Municipal and Corporate Bonds. In these cases, the issuing party is the option holder and the investor is said to be “short” the options. It is up to the issuer of the security to decide whether to redeem the bond early, at a series of predefined call dates. These call options tend to be all or nothing, meaning that at each call date either the bonds get redeemed in full, or stay intact until at least the next call date.
Loans are written with a set of terms that define the contractual principal and interest repayment schedule. Some loans have prepayment penalties that discourage borrowers from paying down loans early, but many loans, including most mortgages, are free of such penalties. Borrowers will pay down or payoff loans early for a variety of reasons, including relocation or sale of the collateral. Especially in the case of 1-4 family mortgages, refinancing is a key component of loan prepayments. If a borrower is able to refinance a loan into a lower interest rate, many will do so. Each loan is unique, as each borrower has his or her own set of financial capabilities, understandings, motivations and circumstances. As a result, the exercise of prepayment options in a loan portfolio will tend to be a bit more random and difficult to precisely forecast.
Securities such as Mortgage Backed Securities (MBS), Collateralized Mortgage Obligations (CMOs) and Asset Backed Securities (ABS) will have cash flow characteristics impacted by these same prepayment behaviors.
Impacts of Options on Interest Rate Risk
For the purpose of modeling the future cash flows of instruments with embedded options, it is industry standard practice to assume that the option holder will act in its own best interest. If a bond is issued at par with a coupon of 5.00%, and interest rates subsequently fall, the issuer is now able to issue new debt at lower rates (3.00%) and would do so, using the proceeds to payoff the initial higher cost bonds. Similarly, most borrowers with a 6% mortgage would be expected to refinance into a 4% loan, given the opportunity. Issuance costs and other market inefficiencies can mitigate this behavior, especially in cases where the future interest savings are small.
As we have established, callable bond and loan portfolios will tend to shorten when interest rates fall, and extend when interest rates rise. When simulating future interest income, more callable bond and loan balances are repaid sooner when rates fall, resulting in a larger decline in interest income due to reinvestment at lower interest rates. Conversely, when rate rise, fewer dollars are repaid and eligible for reinvestment at higher rates. This causes a downward curvature (also known as negative convexity) in the interest income forecast.
Similarly, when calculating the fair value of loans and callable bonds under various interest rate scenarios, the shorter cashflows when rates fall mitigate some of the price appreciation you would see in a portfolio free of these options. The extension of the cash flows when rates rise serves to magnify the loss in value of these instruments relative to a portfolio free for these options. Again, this results in a downward curvature of results commonly described as negative convexity.
As will most things in life, options are a zero-sum game. The benefits of options granted to bond issuers and borrowers are borne on the banks and credit unions that grant them. It is also true that options have value, and banks and credit unions are compensated with higher rates for granting these options to their counterparties.